Global Economics

Crisis Call: Is Sony Ericsson Heading for Divorce?


The joint venture in mobile phones is dragging on both parents and needs a lot of cash. Can Ericsson let it go? Could Sony afford control?

Sometimes it's easier to stay in a troubled marriage than to undergo a costly and messy separation. Consider Sony Ericsson, the world's fifth-largest maker of mobile phones. The eight-year-old joint venture between Japanese consumer electronics giant Sony (SNE) and Swedish telecom equipment maker Ericsson (ERIC), has weathered more than its share of ups and downs. But now, with sales tanking and losses soaring, rumors abound that one—if not both—of the companies may be pushing for a breakup.

Both partners insist divorce isn't an option. Even after Sony Ericsson warned on Mar. 20 that first-quarter shipments would be down by nearly half from the previous quarter and that losses could be as high as $530 million, the two parents continued to affirm their commitment to the venture. "Sony and Ericsson are determined to work with Sony Ericsson's management team to turn the situation around and return the company to profitability," the companies said in a joint statement.

That's a huge challenge. To give Sony Ericsson a chance to engineer a turnaround by 2010 will require an infusion of at least $1.4 billion in additional capital, figures brokerage Nomura International. Without it, the company could burn through most of its current $1.6 billion cash pile as soon as August, estimates Richard Windsor, Nomura's global technology specialist in London. "The situation at Sony Ericsson is relatively precarious," Windsor says. "The perception is that it could easily become the next Motorola."

midrange handset sales are plunging

That's a far cry from where Sony Ericsson was as recently as two years ago. After a rocky start to the joint venture, the company's hip brand image and products such as the Cybershot camera phones and Walkman range of handsets proved popular with consumers, helping to propel it to the No. 3 position among cell-phone makers for a brief period in 2008.

But success was short-lived. Last year, as weakening economies started to take a bite out of sales, the global handset market grew by just 3.6%—and Sony Ericsson's volume fell by nearly 7%. This year, "the global handset market is expected to shrink between 10% and 15%, and it's the midrange segment of the handset market—the area where Sony Ericsson has traditionally been the strongest—that will be hit the hardest," says Nomura International Executive Director Stuart Jeffrey.

One reason: It isn't enough these days just to offer imaging and music. Witness the success of the Apple (AAPL) iPhone, with its slick features and über-cool brand image. "Touch screens, GPS, Internet browsing, and social networking are the hot areas of the handset business and Sony Ericsson has not made significant inroads into any of them," says Carolina Milanesi, research director for mobile devices at telecom consultancy Gartner (IT) in London.

U.S. operations chief just quit

A big part of Sony Ericsson's current problem, analysts say, is that it has built the wrong portfolio of handsets. The mobile market has become increasingly polarized around ultra-basic devices such as the $50 Nokia (NOK) 2600 and high-end smartphones like the BlackBerry, iPhone, or Nokia N96. Yet Sony Ericsson has remained firmly mid-market.

The company has tried to move upscale, but with only limited success. Last year it launched a pricey smartphone called the Xperia built around the mobile version of Microsoft (MSFT) Windows. Although the device was mainly aimed at the U.S. market, where Windows Mobile has a stronger following, Sony Ericsson hasn't yet managed to persuade either T-Mobile (DT) or AT&T Wireless (T)—the two main GSM mobile operators in the U.S.—to offer it. Analysts speculate such problems may be one reason Najmi Jarwala, president of Sony Ericsson's U.S. operations, announced on Mar. 23 that he was leaving the company "for personal reasons."

Sony Ericsson says it has taken action to pare back the number of mid-priced models in its portfolio and to invest in higher-end devices. It aims to introduce a range of gizmos using a variety of operating systems, including Windows, the Android platform from Google (GOOG), and the Symbian OS from London-based Symbian.

A $1.5 billion loss this year?

A greater commitment to smartphones makes sense. The pocket-sized computer-like devices are expected to account for around 17% of all handsets shipped this year, according to Tina Teng, a Los Angeles-based senior wireless communications analyst with market researcher iSuppli. Despite the global downturn and expected overall decline in cell phone sales this year, smartphone sales are expected to grow by an average of 21% a year through 2013, Teng says.

But launching a range of new smartphones will take money and time. If drastic changes are not made, Sony Ericsson might lose as much as $1.5 billion this year, RBS Capital Markets (RBS) analyst Mark Sue said in a recent research report. "Ericsson's core wireless infrastructure business is humming along, so we don't know why it's sticking with the joint venture," he writes.

It's a question that crops up increasingly often. Back when the venture was formed in 2001 by combining also-ran mobile phone units at Sony and Ericsson, keeping a stake in handsets made more sense for Ericsson. If the company was launching a new network technology, it could guarantee that compatible handsets were there to use it—ultimately helping Ericsson win more contracts. But that's less relevant now as Ericsson focuses on open network standards, Nomura's Jeffrey says. "It no longer matters if Sony Ericsson is the company supplying the handsets," he says. Besides, the mobile industry today is more focused on software and digital content than on hardware.

Ericsson gains knowhow and royalties

With Sony Ericsson facing losses and in need of cash, many in the industry believe it would be in Ericsson's interest to cut its losses. The problems with the venture mean Sony Ericsson is likely to continue to drag on Ericsson's earnings and cash flow for at least the next two years. And "while long-term upside potential would be lost in the event of Ericsson's selling its holding, there's no guarantee that any upside will prove material," says Nomura's Jeffrey.

Ericsson has its own reasons for not selling. For starters, says spokeswoman Jana Mancova, the company's customers still believe it's important for Ericsson to have handsets in its portfolio to maintain intimate knowledge of mobile technology from "end-to-end." Another complicating factor is that Sony Ericsson relies on many of Ericsson's patents, providing the Swedish company with a high margin income stream, Nomura's Jeffrey notes.

Nevertheless, many in the industry believe Sony would gain a lot by taking full control of the venture. The Japanese company could exert more control over products and strategy, as well as offering a full portfolio of smartphones, laptops, and netbooks under its own brand name. Bringing mobiles in-house also could foster greater collaboration between the handset business and Sony's other electronics and content divisions, with the goal of improving the mobile user experience. Both Sony CEO Howard Stringer and Kazuo Hirai, the former Sony PlayStation head who was recently promoted to run Sony's new networked products and services unit, have emphasized mobile as a key strategic area for the company going forward.

A Buyout by Sony would pile on debt

Some observers speculate that Hirai's promotion is evidence that Sony might want to develop a PlayStation mobile phone on its own. After all, Hirai is tasked with "developing new mobile products." But Sony has dismissed this idea as "pure speculation." Moreover, Sony Ericsson says it has never doubted that Sony would be willing to license the PlayStation brand to the venture. The reason for the delay, the company says, is "we have previously felt that the technology to create a really integrated gaming phone was not there, but we are getting closer."

With plenty of problems in its own business, some question whether Sony would be willing and able to finance a full takeover and recapitalization of the venture by itself. Analyst David Gibson of Macquarie Securities (MQG.AX) figures Sony could snag Ericsson's stake in the company for $1.6 billion, but in a note to clients he points out that doing so would lift Sony's net debt-to-equity ratio from 12% currently to 30% by this time next year.

"The benefits of such a deal are likely to be some time away and go against the rationalization strategy in the rest of the Sony business," he notes. Considering that Sony has struggled for three years to make its television business profitable, investors are unlikely to applaud another troubled business depressing the company's earnings.

Yet with Sony Ericsson needing cash soon, Sony and Ericsson need to figure out fast whether to bring in the divorce lawyers—or just to seek a good relationship counselor.


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